I am an undergraduate student studying economics while working as a strategic business analyst at a mortgage servicing firm. My undergraduate focus is on behavioral economics and I am currently coauthoring a paper on the discounting of systemic risk as a result of a complex intermix of... More

Every investor knows that nationwide residential real estate is a pretty safe investment compared to most equities. After all, housing prices never decline in national markets. At a time where equity markets are perhaps overbought, it's best to stay away from stocks and go with safe returns in high yielding sub-prime mortgage backed securities since there is no real risk of principal loss.

Every investor knows that bonds are pretty safe and stocks are risky. Bonds, barring default, always retain their face value. In uncertain times, it's best to stay in bonds for capital protection and let the equity market figure out where it wants to go.

Five years ago, both of these statements would be accepted as reasonable by most. Today, the first of these statements would be met with ridicule, and yet the second would be hotly contested by most. Why is the second statement still accepted by most when both statements fail to appreciate systemic risk that both markets face? The investment world probably knows of a "black swan" - but what causes the black swan? The answer lies in normalcy bias.

Normalcy bias is a cognitive bias that is sourced from a simple idea. In general, human minds are extremely poor at preparing for what has never happened before. The seeming inevitability of something does not change the perception: unless it has happened, it probably won't happen. In the financial world, this perception goes even deeper: "if it hasn't happened in my trading lifetime, it won't happen." After all, markets are now different then they were years ago: the old rules don't apply in this modern era of tight market efficiency.

How else can you explain the housing bubble? Anyone looking at a historical chart of housing price versus median income could have seen it coming. Despite all of the brilliant minds working on creating and valuing the bubble, few prepared for the magnitude of the collapse. Sure, there were some dissenters, and sure, there were some who knew that the market was due for a slight correction. But the floor would never simply fall out from beneath like it did. That was impossible: it's never happened before.

Today, we face a new bubble: the bond bubble, especially in US treasuries. This one has been slow to form, but has been growing ever since 1985 when fears of inflation subsided. Yields have been declining precipitously ever since. With long term investment grade debt yielding around 5%, and 30 year US treasuries yielding at 3.7%, there isn't much room for further yield decreases.

There is a perceived safety that bonds present to the investor: after all, barring default risk (and a properly diversified investor can certainly manage that in a quantitative way), you are guaranteed to get back your principal investment with the coupon interest. What could be better?

Just like the MBS market, however, there lies a systemic risk. With the MBS market it was rapidly declining housing prices. With the bond market, it’s inflation and interest rate risk. For the United States market it is easy to forget that inflation - and even real interest rates - can always rise. The United States has faced a mostly declining real interest rate and relatively moderate inflation rate for the past two and a half decades. It is easy to accept this as the status quo, and that this will always be the case. Some people even forget that as recently as 2008 the CPI increased 3.8% - .1% higher than the 30 year Treasury bond yield as of this afternoon. Despite this inflation amnesia, there are some strong inflationary and real interest rate pressures that will be facing the US in mid-to-long term future.

Many believe that the United States is headed in a Japan-like direction: a long period of somewhat stagnant growth and deflation or, at the very most, very low inflation. Japan is, however, a red herring: the United States is not like Japan. Japan's deflation and low interest rates were caused by a large current account surplus, high internal savings rate, demographics, and an asset bubble that makes the US housing bubble look like a small hill. With an export driven economy, the currency has no choice but to appreciate, which inevitably creates deflationary pressures.

Compare this to the United States: a huge current account deficit and a country totally reliant upon foreign capital injection to keep low interest rates. In the event of stagnant growth in the US, we will see capital flight and further currency depreciation. These are both outcomes that lead directly to inflation and/or real interest rate increases.

If growth was to continue, the United States still faces an increasingly inflationary environment due to inevitable currency devaluation. Further, the Federal government will continue to compete with firms for free capital to fund its spending binge. In addition, the Fed, while independent, is not immune from government pressures. It is not unreasonable to expect a push towards slightly higher inflation to mute the impact of the rising public debt burden. Regardless of outcomes, growth or no growth, the United States faces a very real possibility for interest rate rise and inflation. The US can only rely on cheap foreign capital and currency subsidization from artificial demand for so long.

Many may argue that such macroeconomic changes would be slow and would not create a drastic market collapse. This may be true, but it is not unrealistic to also expect a dramatic spike in yields at the first sign of trouble. A vicious cycle could begin if the USD begins to devalue at a quick clip. Non-state foreign investors may begin to flee from the "safe" treasuries and corporate bonds, creating a yield spike and further dollar devaluation - two forces that work in the same direction to scare off even more foreign investors. The Fed would be powerless to stop such a run since loose monetary policy would just further devalue the dollar in such an environment. In a very short time, trillions of dollars of bonds - US treasury and otherwise - could be trading at a significant discount to par value. In this scenario, even the lethargic bond market is subject to rapid pop and collapse. A nightmare scenario? Perhaps - but so was the financial malaise created by the ill-fated housing market.

The purpose of this diatribe is not to claim that this is going to happen. Interest rates may stay low, and who knows, the US may enter a period of prolonged deflation or neutral price levels. No one can predict the future with certainty. The point is that there are very real and possible systemic risks facing the bond market - and it is unlikely that these systemic risks are priced into the market given the record low yields - both real and otherwise. Normalcy bias means that what was just discussed simply can't happen: after all, it hasn't happened before, so why would it happen now?

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